Factors are measurable characteristics of listed stocks that may in some way be predictive of future performance. Probably the most well understood factor is the price to earnings (PE) ratio. Stocks that have low PE’s tend to outperform other stocks in the future (this is often referred to as “value” investing). As quantitative analysts we measure loads of these factors and then test to see whether they have any predictive power. The most successful of these are included in our factor model for predicting stock performance.
We group factors according to the fundamental arguments as to why they work. We call these groups styles. We then create a composite score for each stock, combining the scores for each of the factors into a style score. We track four major styles, being value, growth, price momentum and earnings momentum. The value factors seek to identify equities that are cheap; growth factors seek to identify stocks that are growing faster than the market average; earnings momentum reflects stocks that are growing their earnings faster than their peers; and price momentum seeks to invest on trends, arguing that stocks that have outperformed will continue to do so.
For each factor we rank the stocks according to the particular measure. We then form a market neutral portfolio that consists of equally weighted long positions in the top fifth of the stocks and equally weighted short positions in the bottom fifth. The performance of this “factor-mimicking-portfolio” is then assigned to the factor. This is done on a monthly basis and the monthly performances are compounded to create longer term factor performance.
Style performance is calculated in the same way using the composite style score which is a weighted sum of the underlying factor scores. It is important to note that due to its composite nature, the performance of the style will not be a weighted average of the factor performances. Style performance will reflect the returns of a long-short portfolio formed from stocks that have the best and worst “style” scores.